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Bill to tighten rules on ratings agencies has big loopholes

WASHINGTON — A key House of Representatives committee is set to vote soon on legislation that would overhaul financial regulation and produce greater transparency for investors, but as it's now written it fails to address many of the credit-rating agency missteps that helped fuel the global financial crisis.

The House Financial Services Committee was scheduled to approve the Accountability and Transparency in Rating Agencies Act on Wednesday, but on Tuesday it postponed the vote for a week. The measure would require greater transparency from the three major bond-rating agencies — Moody's Investors Service, Standard & Poor's and Fitch Ratings — about the methods they use in rating bonds.

The legislation is designed to strengthen the bond-rating agencies' compliance offices, which failed to alert investors that complex securities backed by U.S. mortgages were of poor quality, even though they'd received top investment-grade ratings.

A McClatchy investigation published Sunday, which quoted whistleblowers inside Moody's, found that Moody's gave high ratings to securities that it knew were of poor quality because it didn't want to lose business to competitors.

Despite widespread evidence of weakened lending standards from 2005 to 2007 and an unsustainable run-up in home prices, especially in hot markets such as California and Florida, the ratings agencies continued to provide top investment-grade ratings to mortgage-backed securities. When the bottom fell out of the housing market in late 2007, especially for sub-prime mortgages given to the least creditworthy borrowers, the triple-A ratings for mortgage-backed securities were downgraded rapidly to junk. Investors were left holding the bag.

Moody's stock, which peaked above $72, is now off by almost $50 from that high.

As part of a broad regulatory overhaul proposed by the Obama administration, House and Senate banking panels are trying to fix what went wrong, especially at the ratings agencies, whose blessing on a bond or security tells investors that it's trustworthy.

The draft legislation proposed by Rep. Paul Kanjorski, D-Pa., goes farther than Obama's recommendations, but it doesn't address some of the ratings agencies' most egregious abuses.

"I think that it's well-intentioned, but I'm afraid it will have little practical effort," said Eric Kolchinsky, who was a managing director in Moody's structured finance division from January to November 2007, when he was purged, he said, for questioning ratings methodology. (Moody's denied that.)

"It does little to alter the fundamental flaws of the rating agencies' role in financial markets," Kolchinsky said of the bill.

Most abuse came in the agencies' structured finance divisions, which assisted Wall Street in packaging pools of mortgages into securities whose supporting income stream came from U.S. homeowners' payments on their mortgages.

Kanjorski, the chairman of the House Financial Services Subcommittee on Capital Markets, would create a separate rating system for complex securities rated by structured finance divisions. It also would minimize the conflicts of interest that stem from the bond-rating agencies' practice of advising on the makeup of these securities and then receiving handsome payments for rating them.

Several sections of Kanjorski's bill discuss how to disclose information to the public about when an outside "third party" does due diligence on underlying mortgages or other loans that are being rated. However, the bill wouldn't require such independent due diligence, which was sorely missing during the boom in home prices.

A former Moody's analyst who's familiar with the rating process for bonds backed by sub-prime U.S. mortgages said that analysts in his department were aware of the shoddy lack of research behind bond ratings, but management determined that it wasn't the company's job to verify borrowers' abilities to pay their mortgages or to do any other form of due diligence.

"It was broached at meetings, but it was decided that once you do it for one, you do it for all of them," said the former analyst, who contacted McClatchy after reading the investigative piece. The former analyst demanded anonymity in order to protect his reputation on Wall Street.

The culture at Moody's, this former analyst said, was "don't attempt to look any further because it's not our job. The question always is, 'Who is going to pay for the due diligence?' "

The House legislation would direct ratings agencies to include at least two independent members on their boards of directors, and would mandate that compliance officers report to the boards. It wouldn't direct the Securities and Exchange Commission to work with the compliance officers, however, which could have helped regulators understand the looming sub-prime crisis in 2006 and 2007.

Moody's has refused to make top executives available to McClatchy, and one prominent member of its board of directors, Harvard University business law professor Robert Glauber, didn't return calls and e-mails requesting comment. Glauber headed the National Association of Securities Dealers from 2001 to 2006, a trade group that was merged into the Financial Industry Regulatory Authority, a self-regulation arm of the industry that failed to avert the global crisis.

One former Moody's chief compliance officer told McClatchy that more changes should be considered to strengthen compliance departments.

"These might include a provision that the designated compliance officer could only be hired and fired with the approval of the board, that he or she be appropriately qualified and not have been employed in one of the firm's business lines within the past three years, or for three years following their departure from the post, and that the SEC meet in person with the designated compliance officer on an annual basis rather than simply receive a report which has been reviewed and revised by management," Scott McCleskey said. He's now the U.S. managing editor at Complinet, an online service for financial risk managers.

The legislation would make it easier for investors to sue ratings agencies, but plaintiffs would have to prove outright falsehoods, not just negligence.

"This element is extremely difficult to prove where the rating agency effectively remains the sole source and arbiter of the information in question," Kolchinsky said.

The former Moody's analyst who spoke anonymously said the bill would benefit small individual investors. It would require the ratings agencies to make full public disclosures of their modeling and methodology behind particular ratings.

Importantly, it also would force them to publish preliminary ratings so that investment banks no longer could sit on one rating while shopping for a better one from competitors.

However, there's no explicit requirement to provide detailed cash flow and default assumptions in a ratings agency's model, an important part of what went wrong in the mortgage finance debacle. Investment banks disclosed one set of assumptions about how a security would perform, while ratings agencies focused solely on default assumptions, effectively comparing apples to oranges.

Several whistleblowers told McClatchy that this was how Moody's mashed the numbers to arrive at the favorable ratings needed to get or maintain business from investment banks such as now-defunct Lehman Brothers and Bear Stearns.

"The agencies haven't always wanted to make their models public; it is proprietary information. However, since ratings are somewhat like a 'public good,' I believe this information should be available" to investors, the former analyst said.

Had the information been public, he said, investors would've known that Moody's didn't work off a loss model but only tweaked its basic assumptions to reflect the possibility of greater losses with little quantitative analysis or historical performance studies.

"If Moody's was forced to make all of their analysis public, people would have realized much earlier that the emperor was wearing no clothes," the former analyst said.

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